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Property rights and banking crisis – towards a “Financial Constitution”

I just found a great paper – “A Coasean Approach to Bank Resolution Policy in the Eurozone” – on banking resolution by Gregory Connor and Brian O’Kelly. Here is the abstract:

“The Eurozone needs a bank resolution regime that can work across seventeen independent nations of diverse sizes with varying levels of financial development, limited fiscal co- responsibility, and with systemic instability induced by quick and low-cost deposit transfers across borders. We advocate a Coasean approach to bank resolution policy in the Eurozone, which emphasises clear and consistent contracts and makes explicit the public ownership of the externality costs of bank distress. A variety of resolution mechanisms are compared including bank debt holder bail-in, prompt corrective action, and contingent convertible bonds. We argue that the “dilute-in” of bank debt holders via contingent convertibility provides a clearer and simpler Coasean bargain for the Eurozone than the more conventional alternatives of debt holder bail-in or prompt corrective action.”

I found the paper as I was searching the internet for papers on banking regulation and property rights theory. If we fundamentally want to understand banking crisis we should understand incentives and property rights.

Who owns “profits” and “liability”? Who will be paying the bills? The banks’ owners, the clients, the employees, the bank management or the taxpayers? If property rights are badly defined or there are incentive conflicts we will get banking troubles.

In that sense banking crisis is a constitutional economics problem. Therefore, we cannot really understand banking crisis by just looking at specific issues such as how much capital or liquidity banks should hold. We need to understand the overall incentives facing all players in the “banking game” – owners, clients, employees, bank managements, regulators and politicians.

Inspired by Peter Boettke’s and Daniel Smith’s for a “Quest for Robust Political Economy” of monetary policy we could say we need a “Robust Political Economy of Financial Regulation”. I believe that Connor’s and O’Kelly’s paper contributes to this.

Another paper that helps use get a better understanding of the political economy of financial regulation and crisis is Josh Hendrickson’s new paper “Contingent Liability, Capital Requirements, and Financial Reform” (forthcoming in Cato Journal). Here is the abstract:

“Recently, it has been argued that banks hold an insufficient amount of capital. Put differently, banks issue too much debt relative to equity. This claim is particularly important because, all else equal, lower levels of capital put banks at greater risk of insolvency. As a result, some have advocated imposing capital requirements on banks. However, even if one accepts the proposition that banks hold too little capital, it does not neces- sarily follow that the correct policy response is to force banks to hold more capital. An alternative to higher capital requirements is a system in which banks have contingent liability. Under contingent liability, shareholders are liable for at least some portion of depositor losses. This alternative is not unprecedented. Historical evidence from the United States and elsewhere suggest that banks with contingent liability have more desirable charac- teristics than those with limited liability and that depositors tend to pre- fer contingent liability when given the choice. Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.”

Lets just take the last sentence once again – “Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.” 

Hence, if we want to “design” good banking regulation we fundamentally need a property rights perspective or even in a broader sense a “Financial Constitution” in the spirit of James Buchanan’s “Monetary Constitution”.

Concluding, yes we might learn something about banking crisis and banking regulation by studying finance theory, but we will probably learn a lot more by studying Law and Economics and Public Choice Theory.

Related posts:

“Fragile by design” – the political causes of banking crisis
Beating the Iron Law of Public Choice – a reply to Peter Boettke

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